Tuesday, March 11, 2014

Trading in Your Feathers

There are two main dovish arguments. The first is that we're "nowhere close" to full employment or meaningful capacity constraints, as the Economic Policy Institute's Josh Bivens argues. The second is that, even if we are close, it's worth chancing it with inflation because the benefits of a robust recovery greatly exceed its risks of taking it a bit too far, as The Economist's Ryan Avent and The Financial Times' Cardiff Garcia both have said.

Bivens argues that the U.S. economy hasn't recovered in a significant way. He suggests the output gap has shrank by less than half, or perhaps even less than a third. It's the thoroughest update I've seen on the dovish case. What it boils down to is that the output gap looks big and employment is still depressed, and there's no evidence of price inflation or fiscal crowding-out.

Where do Bivens and I diverge? We definitely do. The key part about most definitions of full employment is the behavior of wages. You know you're at full employment when you see wages increasing in a big way. You know you're not when wage growth is quiet. This is why I am watching the wage determination process and at quits. There's really no way to get to that definition of full employment from estimates of the output or unemployment gaps, as that assumes the level of potential, the essence of what you're trying to prove. Inflation comes closer, but it will likely lag wages.

What I'd love to hear him answer: The U.S. is seeing 8 million too many quits a year for there to have been no reduction in slack in labor markets. That's 6 percent of total employment. In fact, quits suggest the unemployment rate is accurately measuring labor-market slack.

Avent's and Garcia's arguments are more interesting, and we agree much more than we disagree. Both are willing to accept that the output gap isn't quite as large as Bivens suggests. Yet Avent and Garcia both say it's worth pressing onward because we might be able to recoup lost capacity, give wages a boost after a long period of stagnation, and because a macroeconomic equilibrium with slightly higher inflation and higher nominal interest rates is in itself desirable. The last point is that when inflation and interest rates are too low, it renders monetary policy impotent as a tool to fight future recessions.

Right. There's no doubt that the costs and benefits of an "overshoot" of full employment are asymmetric. Stay too loose for too long, and you get a temporary bit of inflation. Exit too early, and you leave the work of fixing the recession unfinished forever. Who wouldn't take the first one?

The problem with this cost-benefit logic is that the consensus policy track already agrees with it, as do I, to the extent to which the logic works. Futures markets anticipate the first rate hike in the fall of 2015. Rate are then set to rise about one percentage point per year. This locks in a solid amount of "overshoot" already.

How do I figure that? The unemployment rate is 6.7 percent. It has fallen roughly 0.8 percentage points per year. Extrapolate forward to the fall of 2015, and you get that the first rate hike will happen with an unemployment rate of about 5.5 percent. The Fed's estimate of the natural rate of unemployment is 5.2 percent to 5.8 percent, and the middle of that range is 5.5 percent.

Markets therefore expect the Fed to cross its own estimate of full employment with its policy rate at zero. That's extraordinary. See the graph below. By the time the hikes actually kick in -- 2016 and 2017 -- unemployment could be the four-percent range. It's hard to see how that exit wouldn't produce an overshoot and a jump in wages, and how that wouldn't be sufficient to get interest rates way off the zero lower bound.

Jared Bernstein and Dean Baker, who also wrote in response to my piece in Bloomberg, say that quits aren't that high, and that 6.7 percent unemployment is still way above full employment. What the graph above shows is that this is really a matter of degree. 6.7 percent is above full employment, yes, but full employment is two years away.

So here's what I don't get: What more do Avent, Garcia, Bernstein, and Baker -- and more generally, the doves who say they disagree with me -- want? I owe Ryan L. Cooper a shout-out here, too.

Their implication is that a yet larger overshoot is desirable. Much of their arguments are abstract, but the specifics make it almost unbelievable: Should the first rate hike really come when unemployment has a four in the first digit? I'm all with them until that point.

I think the expected path for monetary policy is already dovish, and wisely so. It was an awful recession. But there really is such a thing as "too much." This is already quite a lot. And to say that the current policy path is broadly appropriate, as I've done, really does imply that it's time to start talking about how tight the labor market is, about how much slack the U.S. economy has left, and about tightening.

The reason the Fed is tapering now and talking ever more frankly about rate hikes is ultimately because yes, it's about time.


Updates (3/13 wrote post, 3/14 added chart)

This post received further responses from Ryan Avent and Dean Baker, both of whom say that a linear projection for unemployment is overly optimistic. Alright. I didn't want to overcomplicate it.

Baker suggests that unemployment will fall 0.3 percent a year for the next three years, given GDP growth and productivity forecasts. I think that's unrealistically low. It's quite likely that labor-force dropouts continue to elevate that rate above what we might expect from GDP and productivity. In the case that he's right, though, and we wake up in mid-2015 with the unemployment rate still in the mid-6-percent range, I wouldn't object to his policy prescription. Nor would, I think, the Fed. No need for tightening then.

As Avent points out, the Fed's forecast is that progress on unemployment will slow down, though not to 0.3 percent per year. Last December, they saw unemployment between 5.8 percent and 6.1 percent by the end of 2015. I think it's likely this forecast is revised lower next week; the unemployment rate has dropped 0.3 percentage points since then.

But even if you don't, my basic point wasn't super sensitive to small differences in the unemployment rate. 5.8-percent unemployment still means the first rate hike comes as the Fed hits its own threshold for full employment. Hikes that proceed at one percentage point per year still mean that, at the end of 2016, the Fed will have its policy rate at one percent while unemployment is in the low-5-percent range.

When you compare that to Fed exits from the 1990 and 2001 recessions, it is clear that this is already a departure from the norm, and to the dovish side. And rightly so. This is not 1990 or 2001. Yet waiting until 2016 or 2017, as Brad DeLong suggested in his excellent overview of the debate, would also seem imprudent, as I've argued above.

Avent argues that none of this is overshooting unless inflation rises, and markets don't expect higher inflation, judging from breakevens. I think this is the right argument. Perhaps it is that markets think the Fed can get away with the moderate overshoot it has planned -- overshoot in terms of real potential -- without much of a rise in inflation.


  1. Wages are not the only dimension of compensation. There are non-cash benefits, and there is also job quality and (for lack of a better word) "respect." For example like being treated more deferentially because its hard to find good people (see for example the Atlantic article you tweeted). Employers will put up with a lot more B.S. when its hard to find a replacement than when they can hire two people tomorrow with a better attitude.

    In places like North Dakota, where the job market is really tight, employers will even waive the criminal background check so long as you show up. It's funny how employers can find all sorts of creative ways to squeeze seemingly non-qualified people into jobs when they are desperate.

    So, the bottom line answer here is yes, we should really be waiting until standard unemployment has a 4-handle, or the wider unemployment (U-6) has a 6-handle until we start raising rates.

    And, the best way to prevent overshooting is to hold the line on ngdp growth at 6%, at least until we are clearly at full employment.

  2. "but full employment is two years away." We'll see how well this post holds up. A lot depends on Yellen.

  3. As a dove, I'd like to close the output gap, and hit 2% inflation for a sustained period to help minimize the real value of past nominal debts to help consumer and business balance sheets at least.

  4. Evan, I think the logic of the doves is quite simple, and it is that they want an *immediate* increase in the rate of job growth. Why should we be waiting two years for full employment when we can move that date forward by 3 months, 6 months, a year, what have you.

    I'm with the doves on this, primarily because the Fed has now adopted a policy of following up recessions with tight money and anemic job growth, which likely makes the problem of long-term unemployment much worse. We need policy that is much more countercyclical than what the fed has given us these last 6 years.

  5. Crickey, do we have to be so timid and fancy-pantsy when output is depressed, unemployment is high and unit labor costs dead in the water? Has the econ profession turned into a crank craft, peevishly fixated on inflation when real output is suppressed?

  6. I'm troubled by the sanguine nature of the commentary on interest rates by all concerned.

    The bond markets I've experienced over the last 40 years are highly volatile, discontinuous markets. I remember panic and fear of high inflation, or fear of reduced income, making interest rates respond in step-changes. What doesn't happen is a gently sloped curve that responds to employment data.

  7. "full employment" surely has to be more concerned with total employment and employment participation rates? Since 2010, "unemployment rate" is not really the most accurate way of measuring full employment -- and that, in itself, is a problem.

    It means that 4% unemployment rate might still have too many folk not working.

  8. A tighter labour market does not necessarily signal rising inflation. Even robust wage growth need not lead to inflation if it is accompanied by strong increases in productivity. There is definitely some indication sthat companies have held back on productivity enhancing capex since 2009 which could lead to a backlog of productivity enhancing investments which could see a strong period of productivity growth. If that is the case then even a tight labour market does not mean that either the output gap is closed or that wage rises will lead to inflation, rather we should see that wage rises will lead to inflation only if they are not accompanied by appropriate growth in productivity.

    There is also the possibility that rising labour costs lead to a decline in the corporate profit margin rather than increases prices.

    The economy is multidimensional, and it is not clear which constraint will bite first. So we should continue with ZIRP at least until core inflation and 5/5 expectations are back at 2%. I think this could be further off than people imagine.

  9. ya labor's not that well organized and a lot of oru stuff comes from out there in the world. inflation is very low right now even as quit rates and mainstream-published unemployment indicate tighter labor markets. also the US has an enormous national debt that might could use some soothing

    I'd think the only thang discouraging further QE was environmentalism